Hot streak illuminates utility sector's strength

Utilities stocks are on a winning streak so convincing that it may cause investors to forget the long series of ups and downs they've endured.Decades of regulatory snafus, fumbled new ventures and outright scandal have faded away to reveal a robust, focused industry. It has also benefited from low interest rates and merger potential.

Utilities funds--traditionally valued for dividends and steady, if unspectacular, performance--have been roaring: They are up 15 percent in 2007, double the performance of the average U.S. diversified stock fund. They've gained 41 percent in the past 12 months and have a three-year annualized return of 27 percent, according to Lipper Inc.

"Utilities have gone from value stocks to growth stocks," said Gregory Phelps, a portfolio manager with the $1.37 billion John Hancock Tax-Advantaged Dividend Income fund, a closed-end fund with more than half its assets in utilities. "Earnings growth is the best in four decades, they have gotten back to their core competencies and they are growing their dividends again."

Despite the sector's run-up, some experts still see opportunities.

"This sector has done well and valuations are up, yet a lot of utilities stocks have good fundamentals and are still a good buy," said Paul Franzen, utilities analyst with Edward Jones in St. Louis. "We're seeing improving fundamentals in credit ratings, dividends, cash flow, balance sheets and management teams."

The utilities stock game over time has run hot and cold:

-- Utilities were solid investment citizens in the 1950s and 1960s. Then they began to build ambitious nuclear plants in the 1970s and 1980s; regulators often pulled the plug because of enormous cost overruns.

-- They were staging a comeback in the 1990s. Then came huge write-offs after managers disastrously invested in unregulated foreign utilities, real estate, savings and loans, and retail stores.

In 2002, however, utilities began to shed their biggest mistakes and return attention once again to their core operations.

Regulation, of course, will always be an issue. But at least for now, thanks to regulators who don't want responsibility for blackouts or other serious problems, utilities are actively replacing and upgrading their infrastructure.

Functioning like a bond with a little added growth, utilities stocks will experience pressure if interest rates go up, Franzen said. Utilities stocks are income securities that compete with bonds through their dividend and must borrow to grow.

Yet he doesn't believe investors should try to time the market based on rates. Holding quality utilities long term is the way to go, he said; investors who stayed on the sidelines the past three years missed one of the market's best-performing sectors.

"Regulation has always been cyclical, and we are probably swinging to a more difficult time because energy prices have gone up quickly," said Shaun Hong, a portfolio manager of the $5.19 billion Jennison Utility Fund. "It will be tougher to make money with these stocks, so one has to be selective."

Mergers and acquisitions have had a significant role in the utilities story during the price run-up.

A total of roughly $100 billion in utilities deals have been proposed in Europe the past two years because of an easier approval process there.

The U.S. also has seen deals, most notably Kohlberg Kravis Roberts & Co.'s $45 billion plan to acquire Dallas-based electrical utility TXU Corp., which has spawned insider-trading allegations and political resistance. If it makes it through the roadblocks, it would be the largest leveraged buyout in U.S. history.

"Mergers and acquisitions the next few years will involve smaller companies because people are still digesting the boom of the last few years and regulators are more reluctant to approve really big acquisitions," said Roger Conrad, editor of the Utility Forecaster newsletter in Falls Church, Va. "There will be more deals down the road, but a lot depends on changes in Washington and if there is a less laissez-faire attitude at the federal level."

Utilities with nuclear power, such as Exelon Corp., Entergy Corp., Constellation Energy Group Inc., Southern Co. and Duke Energy, are prime for consolidation, Conrad said. They'll benefit if there is carbon regulation at some point, making them more competitive with coal-fired plants.

Consider investing in Florida-based FPL Group Inc., which has a wind power franchise that's "minting money" right now, he said. "Green" power is an important trend.

As he formulates his portfolio, Phelps studies geography and the regulatory climate along with returns, steering away from investing in utilities in any states where he believes regulators do not permit adequate recovery of capital expenditures. For that reason, he considers the states of Washington, Oregon, Maryland and Illinois unattractive for utilities investment and avoids them.

On the other hand, he said a good regulatory environment in Massachusetts is one reason why he is recommending stock of NSTAR, which has more than 1 million customers in that state.